Reading 65: Mortgage-Backed Securities (MBS) Instrument and Market Features

Book3: Fixed Income

Prepayment Risk

prepayment speeds turn out different than the expectations of MBS investors

What is MBS value based on?

assumed prepayment rate

What happens to MBS value when interest rates decrease?

prepayments speed up due to refinancing and a contraction in the average life of MBS

Extension Risk

risk that repayments will be slower than expected

Contraction Risk

risk that repayments will occur faster than expected

Time Tranching

structure with different bond classes with different maturities

How are Contraction and Expansion Risk impacted by Time Tranching?

they are not eliminated, instead, they are reallocated around to cater to the needs of the investor

In Time Tranching, which tranche offers protection against contraction risk?

tranche that has later maturities

In Time Tranching, which tranche offers protection against expansion risk?

tranche with quicker maturities

Residential Mortgage Loan

a loan for which the collateral is residential real estate

Common Features of RMBSs

prepayment penalties

recourse/nonrecourse loan

Prepayment Penalty

additional payment that must be made to compensate lenders if principal is paid when interest rates decline

Where are prepayment penalties more frequent—US or Europe?

Europe

Recourse Loan

loans where the lender also has a claim against other assets of the borrower for the amount by which the foreclosure falls short of outstanding payments

Nonrecourse Loan

leans that only have the specified property as collateral

Underwater Mortgage/Negative Equity

when the property value falls below the outstanding mortgage balance

Loan-To-Value (LTV)

% of value of the collateral real estate that is loaned to the borrower

Which has more equity in the property—low LTV or high LTV?

low LTV

Which is more risky for lenders—low LTV or high LTV?

low LTV

Debt to Income Ratio (DTI)

measures the monthly debt payments of the individual as a % of their monthly pretax gross income

Which has a low default risk—low DTI or high DTI?

low DTI

Prime Loans

mortgages made to borrowers with good credit, low LTV, and low DTI

Subprime Loans

mortgages made to borrowers of lower credit quality, higher DTI, and higher LTV

Agency RMBSs

either granted by government or guaranteed by a government-sponsored enterprise (GSE)

Non-Agency RMBSs

issued by private entities such as banks

Mortgage Pass-Through Security

represents a claum on the cash flows from a pool of mortgages, net of administration fees

Securitized Mortgage

a mortgage included in the mortgage pool

Pass-Through Rate

the coupon rate Mortgage Pass-Through Securities receive monthly

Collateralized Mortgage Obligations (CMOs)

securities that are collateralized by pass-through MBSs and pools of mortgages

Sequential Pay CMO

typical tranche system where the first tranche is paid in full, and then the next

Short Tranche

the tranche that gets paid off first and has shorter maturities

Z-Tranche

a CMO tranche that receives no interest payments, instead, the interest accrues and is added on to the principal

Period-Only Securities (PO)

pays only principal from the collateral pool, effectively zero-coupon securities

Interest-Only Securities (IO)

pays only interest from the collateral pool

Floating-Rate Tranches

pays a coupon that is linked to a variable MRR

Residual Tranche

rank junior to all other tranches

the equity tranche of ABS for MBS

Planned Amortization Class (PAC) Tranches and Support Tranches

makes predictable payments as long sa prepayment speeds remain within a certain range

Which is typically the lowest tranche?

Z-Tranche or Residual Tranche

Commercial Mortgage-Backed Securities (CMBS)

backed by a pool of commercial mortgages on income-producing real estate

Which has more mortgages in the collateral pool—RMBS or CMBS?

RMBS

What’s the difference between CMBSs in US and Europe in terms of the return?

US —> fixed rate

Europe —> Variable rate

How is CMBS different from RMBS?

RMBS ==> loans are repaid by the owners of the property

CMBS ==> loans are repaid by real estate investors who rely on tenants to provide cash flows

What’s the difference between RMBS and CMBS in terms of credit risk?

RMBS focuses on the credit risk of the borrower

CMBS focuses on the credit risk of the property

What are the types of call protection lenders can have?

Loan-Level Call Protection

CMBS-Level Call Protection

Prepayment Lockout

borrower is prohibited from prepaying the mortgage loan

typically 2-5 years

Prepayment Penalty Points

a penalty fee expressed in points may be charged to borrowers who prepay principal

Defeasance

borrowers uses payments in excess of scheduled loan payments to purchase government securities that is sufficient to make the remaining payments

Which Loan-Level Call Protection limits lenders from prepayment risk?

defeasance

What is the main risk in CMBS-Level Call Protection

balloon risk

CMBS is not fully amortizing usually and so there will be a balloon payment at the end

Weighted Average Proceeds from the Mortgages (WAMP)

regular income from the collateral of a CMBS

Debt Service Coverage Ratio (DSC Ratio)

coverage ratio of the amount of cash flow from a commercial property

What are the two ways to assess Credit Risk in CMBS?

LTV

DSC Ratio